Investing Lessons: Avoiding the Peter Lynch Bias

The single most important lesson I’ve learned about being a successful investor is the need to maintain emotional detachment. Any feelings you may have towards a stock are unrequited. If you love a stock, it will not love you back. And if you hate a stock, it will not give you the satisfaction of responding in kind. (As tragic as unanswered love may be, unanswered hate is often more damaging to your pride.)

A stock is like that unattainable cheerleader you had a crush on in high school. She neither loved you nor hated you; she was completely unaware you existed.

No matter how much you love a stock it will not reward your loyalty by rising in price. And heaven help you if you allow your emotions to cloud your judgment in a short position. I know of no surer way of losing your investment nest egg than to short a stock or other investment you hate. Alas, I know from experience; I shorted the Nasdaq 100 in the fall of 2003. In an outbreak of moral high-horsing that has (thankfully) now been purged out of me, I decided that tech stocks were overpriced and needed to fall further. The Nasdaq had very different ideas, and I was forced to cover that short at a 20% loss with my tail tucked between my legs.

A closely-related investment mistake is succumbing to what I call the “Peter Lynch bias.”

Peter Lynch ran the Fidelity Magellan fund from 1977 to 1990 and had one of the best performance records in history for a mutual fund manager—an annualized return of over 29% per year.

Unfortunately, he also offered some of the worst advice in history when he recommended that investors “invest in what they know.”

On the surface, it seems like decent enough advice. If you stumble across a product you like—say, a particular brand of mobile phone or a new restaurant chain—then it might be reasonable to assume that others will feel the same way. If the stock is reasonably priced, it might make a good investment opportunity.

Unfortunately, “investing in what you know” tends to create muddled, emotionally baggaged thinking. The fact that you like Chipotle (NYSE:CMG) burritos and are intimately aware of every ingredient used in the red salsa does not automatically make Chipotle a good investment any more than your liking of Frappuccino makes Starbucks (NASDAQ:SBUX) a good investment. Rather than give you an insightful edge, liking the product causes you to lose perspective and see only what you want to see in the stock.

If you like a company’s products, try using one of their competitors before seriously considering purchasing the stock. If I had really taken the time to learn how to use an Apple (NASDAQ:AAPL) iPhone or Google (NASDAQ:GOOG) Android device, I probably wouldn’t have gotten sucked into the Research in Motion (RIMM) value trap. Yes, RIMM was one of the cheapest stock in the world when I recommended it last year. But I cannot deny that my decision to recommend it was biased by my ownership of a BlackBerry phone. Likewise, many iPhone owners are probably buying Apple for similar reasons today.

To the best extent you can, try to follow trading rules and use stop losses. What works for one investor will be very different than what works for another. Perhaps you use a hard stop loss of, say, 10% below your purchase price. Or perhaps you use a trailing stop or 20-25%. If you are a value investor, perhaps you base your sell decision on valuation or fundamentals rather than market price. But in any event, my point stands. Lay out the conditions under which you intend to sell and stick to them. Stock ownership is a marriage of convenience with quick, no-fault divorce if your situation changes. Don’t make the mistake of falling in love.

Unleash your inner Spock. For readers who are not Star Trek fans, Spock is an alien from the planet Vulcan who is incapable of feeling emotions. When talking about a stock or watching its price fluctuate gets your heart racing, take a step back and try to look at the investment through Spock’s eyes. Is it logical? Do the numbers make sense? Are the growth projections based on reasonable facts or on optimistic hope? Would you buy a different company if it were trading at the same price multiple?

Admittedly, these are not precise guidelines. But then, another lesson I learned is that it is a mistake to try to be too precise in this business. Follow the lead of great value investors like Benjamin Graham and Warren Buffett by making sure you have a wide margin of safety in your assumptions.

Disclosures: Charles Sizemore has no positions in any securities mentioned.

About the author:

Mr. Sizemore has been a repeat guest on Fox Business News, quoted in Barron’s Magazine and the Wall Street Journal, and published in many respected financial websites, including MarketWatch, TheStreet.com, InvestorPlace, MSN Money, Seeking Alpha, Stocks, Futures and Options Magazine, and The Daily Reckoning.

Comments

I tend to look at companies I know a little about at least (e.g. PG, JNJ, MCD) but try to focus on the company's fundamentals (revenue and earnings growth over the past few years in relationship to P/E ratio, long term debt, free cash flow, managment practices) when buying (or selling) a stock and check my emotion at the door (try to be Spock). It's hard to do that sometimes like with the current situation w/ Apple ... great products that work + fundamentals look good but a lot of people are selling the stock based upon rumors/false information and short-term news and opinions (e.g. only 5 million iPhones sold vs. 8 million expected over the first 3 days).

IMHO, Stop-loss is oxymoron. As Ben Graham said: "You are neither right or wrong if others agree or disagree with you, you are right because your data and reason are right"

If you want to own a stock for long term it should not matter if the stock price drop right after you own it. If you can, you should buy more or else your analysis of the company is not complete or worse - wrong but then you should get out asap. Either case you should not expect stop-loss to save you.

>> The single most important lesson I’ve learned about being a successful investor is the need to maintain emotional detachment.

Most people are naturally social and therefore inclined to stick with the herd. In my experience, most people are also somewhat envious (often without being aware of it). Both traits are a tremendous liability in the stock market. Being realistic about the fact that you're probably in this group is good for your wealth.

BUT.... If you are by nature asocial as well as kindhearted (a non-envious loner), you are hard-wired for value investing. I think we can agree this is a rare breed. From what I know, Buffett, Berkowitz, Klarman and Watsa fit the mold. Of course they are pretty smart too. It helps.

In short, be a stock Spock if you're not hard-wired for value investing. If you're enthused by the notion that the market could offer you your stocks at half the current price, you're an exception. You probably already know stop-loss isn't for you.

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